Gravity has got hold of Wesfarmers’ earnings after a stellar FY21. The interim result was pre-flagged in January, particularly warning on Kmart, but the earnings normalisation has spread across other divisions as well.
WES 1H22 group EBIT of $1,778 million was down 13.6% on last year’s supercharged result. This reversal should extend into 2H22f with soft sales and rising costs likely to feature at the year end result.
We especially note the fall in earnings at powerhouse business, Bunnings where revenue was flat and looks set to plateau for the next couple of years. Excluding the net profit contribution from property ($41 million), earnings declined 4.3% in the period to $1,218 million. The development of Bunnings’ digital offer is making progress with online penetration now at 4.3% and an e-commerce platform launched for commercial customers. This is part of the group digital investment that will spend $100 million in FY22f. We see some earnings risk in this aspect as all businesses are rushing to out-spend each other in the pursuit of digital supremacy.
Bunnings acquired the Beaumonts Tiles business during the period (144 stores) and expanded the Adelaide Tools (rebranding to Tool Kit Depot) business to 9 stores.
Not usually mentioned in a WES review, the WesCEF (chemicals, energy and fertilisers) business topped the class for this result. A 36% increase in EBIT to $218 million was a consequence of elevated gas prices which should persist into 2H22f.
The Kmart Group result was already indicated in a January update. The 55.8% fall in EBIT (excluding Catch Group) to $222 million was on a sales decline of just 10.0%. Trading conditions had improved in 2Q22 as restrictions eased, but customers hesitated to visit stores as the Omicron chapter of COVID flattened confidence. Target’s sales decreased 23.6% for the half which included the closure or conversion of 63 Target stores and 87 Country Target stores. Kmart Group continued to pay staff when no meaningful work was available during lockdowns.
The Kmart Group has also rationalised its floor space by 5%, competitor BIG W has recovered, and Kmart margins are likely to settle slightly lower than pre-COVID levels of 9%.
Higher operating costs also affected Officeworks where 1H22 earnings fell 18%. Some of these cost increases will be temporary as they were related to lockdowns, but inflation is bringing a new dimension to the retail industry outlook.
WES’ inventory has increased by $1 billion. We estimate that retail inventory has increased by 24% from 2 years ago, ahead of retail sales growth of 18%. A balance between inventory and sales growth is more ideal, so we are keeping an eye on clearance activity as this could affect margins.
Investment view
Price inflation is upon us and although WES prefers to mitigate cost increases and offer value to customers, it will pass through price increases when necessary. Inflation is normally a net positive for all retailers where modest price rises more than offset any volume decline.
WES is lapping very strong earnings in FY21 across its retail businesses, and we see earnings growth as lacking over the next two years. The company has great positions in its segments, and this will help it to control cost increases and to act rationally.
Risks to investment view
Higher interest rates and inflation could affect consumer confidence and spending in the next year.
Recommendation
We have retained our Hold recommendation.
